Robert Shiller is the Sterling Professor of Economics at Yale University. He developed a cyclically adjusted price-earnings ratio, called the CAPE ratio. We spoke recently about his research on stock asset valuations and market bubbles. —Charles Rotblut
Charles Rotblut (CR): Can you explain what your CAPE ratio is and what it measures?
Robert Shiller (RS): The basic idea is that you need some measure of value relative to fundamentals. You can’t just look at price per share, which doesn’t tell you how something is over- or undervalued, but price relative to something. It seems to me that earnings is the natural candidate to compare price with. But the problem with earnings as it is used is that people tend to use lagging one-year earnings or projected earnings for the next year. One year is just too short of a time period because earnings are volatile and they jump around. In particular, the business cycle affects earnings. When we are in a recession, earnings tend to be low, for instance. So, I don’t think we should overreact to short-term fluctuations in earnings.
CAPE is called cyclically adjusted price-earnings ratio, and it is cyclically adjusted in the sense that we average the earnings over a longer interval of time. I have been using 10 years, which seems like a very long time for most finance people. People tend to think that something that happened 10 years ago is just so long ago that it is irrelevant. But, the conservative strategy argues that, no, it is not irrelevant and that companies last a long time. In order to really get a sense of their value, you have to look at a 10-year history and that is what I have been doing. I work with a former student, who is now a Harvard professor, John Campbell. We found that real price divided by 10-year average of earnings does actually help predict the stock market.
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